Fitch Rates Los Angeles Dept of Water & Power Water Revs 'AA+' & Affirms Outstanding; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings has assigned the following ratings to the Los Angeles Department of Water and Power (LADWP):

--Approximately $500 million water system revenue bonds, split between series 2010A (Taxable Build America Bonds) and series 2010B 'AA+'.

The bonds are expected to price via negotiation during the week of Nov. 29, 2010. Proceeds will be used to fund ongoing projects in the water system's overall capital improvement program. Bonds will be structured with a 40-year amortization, which is beyond the typical amortization schedule used by LADWP.

In addition, Fitch affirms the following ratings:

--$2.6 billion in outstanding parity water system revenue bonds at 'AA+'.

The Rating Outlook is Stable.

RATING RATIONALE:

--LADWP's service territory is broad and diverse with stable customer growth.

--Management executes sound planning and forecasting practices.

--Water supply diversity provides purchasing flexibility.

--A complex rate structure with adjustment mechanisms helps to ensure adequate recovery of costs, in particular, the costs of purchased water, the most volatile expenditure component.

--LADWP must navigate a lengthy rate process to enact base rate changes within an economically challenged and politically charged environment.

--Capital needs are sizable at $2.8 billion over the next five fiscal years and relate primarily to environmental compliance and the replacement of aging infrastructure.

--LADWP has strong debt service coverage, albeit on the low end of the 'AA+' rating category.

KEY RATING DRIVERS:

--Delays in implementing rate increases beyond what is currently projected, given the decline in financial flexibility that would result;

--Financial recovery to levels in line with LADWP's adopted financial policies in fiscal 2012;

--Appointment of a permanent general manager to guide decisions regarding the utility's long-term business strategy and navigate the city's political and economic climate with regards to rate increases.

SECURITY:

The bonds are special obligations of LADWP payable solely from water system revenues.

CREDIT SUMMARY:

The rating reflects flexibility provided by the local water supply, the ability of the rate structure to respond to large reductions in water sales, and a movement over the next five years to a capital funding structure with 40% provided from revenues. Coverage levels and liquidity ratios are on the lower end of the 'AA+' rating category for municipal water systems, while debt levels are high and amortization is slow.

LADWP provides retail water service to a population within the city of Los Angeles of just over four million. Water supply is derived from three primary sources, including deliveries via the Los Angeles Aqueduct from the Owens Valley and Mono Basin through gravity-flow aqueducts (37% of supply in fiscal 2010, up from 18% in fiscal 2009), local groundwater (14%), recycled water (1%), and imported water purchased from the Metropolitan Water District of Southern California (MWD; revenue bonds rated 'AAA' by Fitch), which typically provides the remaining water supply not available from the other sources (48%). Over the past few years declines in LADWP's water supply were the result of continued drought conditions in California, as well as the availability and price of purchased water from MWD. Due to critically dry hydrological conditions, MWD implemented mandatory 10% reductions in deliveries to its members, including LADWP, effective July 1, 2009. However, LADWP's supply via the LA Aqueduct recovered somewhat in fiscal 2010, providing LADWP the opportunity to purchase less water from MWD. The water supply situation in fiscal 2011 for much of California is beginning to look more robust from a supply standpoint, although demand is still depressed as a result of the economic recession and successful conservation efforts. LADWP continues to address contamination in its local groundwater supply in the San Fernando basin, which is currently restricting the amount of water available from this supply source.

Purchased water costs are recovered through LADWP's rate structure via the water procurement adjustment factor. LADWP has a complex rate structure, with five different adjustment factors, such as the water procurement factor, designed to recover specific costs, and tiered base rates designed to shape demand. The use of the automatic adjustment factors is viewed as a positive credit factor in that variable costs or designated capital costs are recovered directly and not subject to the system's lengthy and potentially political base rate approval process. However, the rate adjustment factors are subject to a cap of $0.50 that does not provide any upward flexibility above what is currently collected. LADWP anticipates that the cap on certain adjustment factors may be increased beginning in fiscal year 2012 in addition to a package of base rate increases that management expects to seek prior to fiscal 2012. While rates are comparatively low, the system has some historical difficulty achieving its requested rate increases, indicating limited rate flexibility. Future rate increases may need to be higher than the system's recent historical 3% annual increases.

Financial performance has declined. Debt service coverage has declined steadily over the past five years. Preliminary indications for unaudited fiscal 2010 is debt service coverage of 1.75 times (x), which is below LADWP's recently adopted (December 2009) target of 2.00x minimum debt service coverage. The decline is the result of below-budgeted water sales and capital pressures requiring substantial additional debt. The lower financial metrics are projected to continue in fiscal 2011, with recovery to LADWP's financial policy targets in fiscal 2012, based on forecasted rate adjustments. Fitch believes the rate assumptions may be aggressive. Liquidity is approximately $200 million in fiscal 2010, or 125 days operating cash. This amount includes $32 million in the Expense Stabilization Fund. Debt levels are high at $3,300 per customer and will climb to over $5,000 in the next five years. Amortization is slow. The use of 40-year amortization for the series 2010A and 2010B bonds reduces required rate increases in the short to medium term at the cost of lowering future debt capacity and financial flexibility. The longer amortization is being used to take advantage of the taxable yield curve offered and federal subsidy offered by issuing Build America Bonds.

The prolonged absence of a permanent general manager (since October 2009) is becoming a credit consideration. While senior management below the general manager level remains in place and provides stability and direction to the business operations, Fitch expects that the decision regarding rates will not occur until a permanent general manager is in place. As noted above, achievement of rates that will provide the utility with financial metrics in line with LADWP's adopted policies in considered a key rating driver.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

'Revenue-Supported Rating Criteria', dated Oct. 8, 2010;

'Water and Sewer Revenue Bond Rating Guidelines', dated Aug. 6, 2008.

For information on Build America Bonds, visit 'www.fitchratings.com/BABs'.

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=564565

Water and Sewer Revenue Bond Rating Guidelines

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=395918

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Contacts

Fitch, Inc.
650 California Street, 4th Floor
San Francisco, CA 94108
Primary Analyst
Kathy Masterson, +1-415-732-5622
Senior Director
or
Secondary Analyst
Douglas Scott, +1-512-215-3725
Managing Director
or
Committee Chairperson
Lina Santoro, +1-212-908-0522
Senior Director
or
Media Relations
Cindy Stoller, +1-212-908-0526
cindy.stoller@fitchratings.com

Contacts

Fitch, Inc.
650 California Street, 4th Floor
San Francisco, CA 94108
Primary Analyst
Kathy Masterson, +1-415-732-5622
Senior Director
or
Secondary Analyst
Douglas Scott, +1-512-215-3725
Managing Director
or
Committee Chairperson
Lina Santoro, +1-212-908-0522
Senior Director
or
Media Relations
Cindy Stoller, +1-212-908-0526
cindy.stoller@fitchratings.com